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If the inflation rate in the United States is 4 percent, while the inflation rate in...

If the inflation rate in the United States is 4 percent, while the inflation rate in Japan is 1.5 percent. The current exchange rate for the Japanese yen (¥) is $0.0080. After supply and demand for the Japanese yen have adjusted according to purchasing power parity, the new exchange rate for the yen will be? Why

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Answer #1

Assuming period of 1 year to for new exchange rate.

Forward exchange rate = Current exchange rate x (1+ Foreign currency inflation rate)/ (1+ Domestic currency inflation rate)

Forward exchange rate = 0.0080 x (1+ 4%)/ (1+ 1.5%) = 0.008197

Forward exchange rate = New exchange rate = $0.0082

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Yen has appreciated because the inflation rate in Japan is lower than inflation rate in US.

The inflation rates pull down the price of currency. Earlier $0.80 was able to buy 1¥ but after a year it will take $0.0082 to buy 1¥.

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